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Why I’ve Bought Chemring Group Plc

As stock markets globally have risen, contrarians seeking out cheap shares, myself included, have found fewer bargains. However, defence company Chemring (LSE: CHG) recently caught my attention.

This company’s share price has been what investors term a ‘falling knife’. Since its peak in 2010 the share price has been tumbling lower and lower after a succession of disappointing results. Last month’s numbers sent Chemring’s shares even lower. In simple terms, the share price is now less than a third of its all-time high.

No company grows forever

At some point, the growth rate of a company that has been booming suddenly slows. When this happens, the market reassesses its view of this company, and often the share price crashes as the company is re-rated. Examples in the recent past of this include car insurance company Admiral and satellite company Inmarsat.

This is basically the market adjusting to reality, as no company grows forever. That’s what you always have to be wary of in-growth companies — after all, no tree grows to the sky. At some point, the growth ends.

But when the share price crashes, often there is too much pessimism. The value of the company crashes further and faster than anyone expects. The fear is that the share price will eventually fall to zero. But if the company is fundamentally strong, and its earnings are steady, the share price will actually recover.

So those who buy at the time of the crash can actually make a tidy profit. This is, as John Templeton called it, ‘the time of maximum pessimism’. How can you judge this? Well, it’s not easy, but I typically look for a discrepancy between the negative sentiment and the predicted performance of the company.

A growth company which has turned into an income investment

This is what I now see for Chemring. It is now rated on a P/E ratio of just 10, which is predicted to be steady in future years — this looks cheap to me, plus there is a juicy dividend yield. Yet the share price has been crashing through the floor.

This is a defence company, and admittedly defence is not a growth sector. But take BAE Systems: last year this was also an unloved, unwanted defence stock. But many canny investors, including Neil Woodford, invested in the company. It turned out to be an astute buy, rocketing over the past year and substantially out-performing the wider market.

This is the art of contrarian investing — it might sound easy, but it is actually really difficult. That’s why most investors can’t beat the market. That’s why the world has only one Warren Buffett.

Our income pick of the moment

Chemring is a growth company that has turned into a value and income investment with recovery potential. Our experts at the Fool have identified another share that we think will grow both its share price and its dividend yield.

We are so confident about this business that it is our top income pick. And we think it could really power up your portfolio. Please read our report about this company, available without obligation and completely free.

> Prabhat owns shares in Chemring.